As noted earlier, small enterprises employing fewer than 50 workers, many of them de novo but also some firms spun off from state enterprises, have been key to generating employment and creating wealth in transition economies. A major policy-cum- institutional challenge facing governments across the region has been the creation of an attractive and competitive investment climate in which restructured and new enterprises have incentives to absorb labor and assets, rendered inexpensive by the downsizing of old and unviable
enterprises, and invest in expansion. This challenge includes reducing excessively high marginal tax rates, simplifying regulatory procedures, establishing security of property rights, and providing basic infrastructure, while maintaining a level playing field among old,
restructured and new enterprises.
The Business Environment and Enterprise Performance Survey, covering a large number of enterprises in over 20 transition economies, and conducted jointly by the European Bank for Reconstruction and Development and the World Bank in 1999,
29
unbundled factors influencing the investment climate into microeconomic variables (including taxes and regulations), macroeconomic variables (including policy instability, inflation and exchange rates) and law and order (including functioning of the judiciary, corruption, street crime, disorder, organizational crime, and mafia)13. According to the respondents, taxes and regulations were consistently among the most important impediments to expansion by new enterprises.
Table 4 reports the number of taxes and the average rates that are imposed on
businesses14. The number of national taxes—profit tax, VAT/sales tax, income tax and social security taxes (in the form of payroll taxes, the latter here consisted as one tax), together with turnover taxes to support various special funds —which is shown in column 5 of the table, is a rough indicator of the complexity of the tax system15. On this measure, Poland and Hungary have the least complex national tax systems, as contrasted with Belarus,
Turkmenistan and Uzbekistan. However, the last four columns of Table 4 also report the extent to which countries attempt to relieve the burden on small firms through tax breaks or simplified arrangements 1617.
Whatever the merits of rules and legislation, the arbitrary bureaucratic harassment to which the administration of taxes and business licensing gives rise continues to be a
significant problem. For example, a survey of some 2000 predominantly small and medium
13 For details, see EBRD(1999)
14 We thank Kjetil Tvedt for producing Table 4, which updates Table 8.3 in EBRD (1999). Definitions on SMEs and micro businesses are those used in national tax codes.
15 Column (4) of the table also reports the maximum rate of personal income tax since businesses registered as sole proprietors and often subject to personal income tax.
16 The column for ‘tax incentive for new start-ups/investments’ emphasizes tax breaks either in favor or disfavor of SMEs. Incentives disfavoring SMEs would be all incentives promoting large investments. Tax breaks for FDIs are interpreted in disfavor of SMEs, based on the assumption that foreign investors normally faces some initial obstacles in form of administrative problems or lack of information, which are in the nature of fixed costs and which play a more significant role for small start -ups firms.
17 General SME tax break is here to be understood as cases when SMEs face a discount in the profit tax because of their size. Simplified tax in form of a gross turnover tax or lump sum tax may cause a reduced tax burden as well. However, the information is not clear on the tax burden following simplified arrangements, and such procedures are never interpreted as an SME tax discount.
enterprises (with a mean firm size of 22 workers and a median firm size of 10 workers) done in Russia in March-April 2002 by the Center for Economic and Financial Research (CEFIR) and the World Bank found that in 2001, between 5 and 21 percent of those who had been in business before and after the passing of legislation designed to improve the investment climate, were visited between 2 and 3 times each by sanitary, police and fire safety inspectors, which is in excess of that prescribed by the law 18.
18 CEFIR and World Bank (2002)
Table 4. SME Taxation
Country GENERAL TAXATION TAXATION RELATED TO SMES
Standard profit tax
Standard VAT
Max.
personal Income tax
Number of national
taxes
VAT turnover threshold (US$)
tax incentives for new start-ups/investments
General SME tax break
Simplified tax for SMEs and sole
proprietors (lump sum or presumptive) Favouring
SMEs
Favouring large firms
Albania 25% 20% 25% 5 57000 No No No Lump sum or gross turnover
taxi
Armenia 20% 20% 20% 4 17200 No Yesii No Lump sumiii
Azerbaijan 27% 18% 35% 4 6400 No No No gross turnover taxi v
Belarus 30% 20% 30% 8 v 6000 No No Yes vi Lump sum vii
Bosnia & Herzegovina (Federation)
30% 24% sales tax
50% 4 No No Yes viii No No
Bosnia & Herzegovina (Rep)
20%-10%
(regressive
18% s ales tax
25% 5 No No Yesix No No
Bulgaria 23,5% 20% 29% 4 33000 No No Yesx Lump sum xi
Croatia 20% 22% 35% 4 6000 No Yes xii No Lump sum
Czech Republic 31 % 22% 32% 4 91000 No Yesxiii No Lump sum
Estonia 26% 18% 26% 4 No No No No No
Georgia 20% 20% 20% 5 11000 No No No Lump sumxiv
Hungary 18% 25% 40% 4 No Yesxv No No No
Kazakhstan 30% 16% 30% 4 25000 No No No Lump sum or gross turnover
tax
Kosovo 20°/a 15% 20% 4 92000 No No No gross turnover tax xvi
Kyrgyzstan 20% 20% 20% 6 2100 No No No gross turnover tax xvii
Latvia 22% 18% 25% 4 16000 No Yes xviii Yes xix No
Lithuania 15% 18% 33% 4 2600 No No Yesxx Presumptive tax xxi
(FYR) Macedonia 15% 19% 18% 4 76000 No Yesxxii No Lump sum
Moldova 25% 20% 35% 4 No Yesxxiii Yes xxiv No Lump sum xxv
Poland 28% 22% 40% 4 9000 No No No Lump sum
Romania 25% 19% 40% 6 1500 Yes xxvi Yesxxvii No Gross turnover tax xxviii
Russia 20-24% 20% 13% 5 (4 from
2003)
No No No No xxix Gross turnover tax
Slovak Republic 25°/a 23% 38% 4 16000 No Yesxxx No Lump sum
Slovenia 25% 20% 50% 4 20000 No No No No
Tajikistan 30% 20% 20% N.A. N.A. N.A. N.A. N.A. N.A.
Turkmenistan 25% 20% 25% 6 Small-scale firms
exempt.
No Yesxxxi Yes xxxii Lump sum xxxiii
Ukraine 30% 20% 40% 5 11500 No No No Gross turnover tax xxxiv
Uzbekistan 26% 20% 36% 6 Small firms are
exempt.
No Yes xxxv No Gross turnover tax or lump sum xxxvi
FRY Montenegro 20% 8-17% Sale tax
40% 4 No N.A. N.A. N.A. N.A.
FRY Serbia 20% 20°/" sale tax
20% 4 No Yesxxxvii No No No
Albania
i Lump sum for micro businesses = annual turnover under 2 million leks (US$14000), 4% gross turnover tax for small businesses = annual turnover 2-8 million leks (US$57000)
Armenia
ii FDI over ADM 500 million (US$ 860,000)
iii Fixed payment for small scale activities such as hairdres sers, gas stations, commercial fishing, and trading activities conducted in locals with trading area less than 30 square meters.
Azerbaijan
iv 2% gross turnover tax when turnover less than 300 times the minimum tax -exempted wage (US$ 6400).
Belarus
v In addition to the standard 4, there is Road tax, Chernobyl fund, Public housing fund, and R&D fund.
vi 50% discount on profit tax for small enterprises = profit less than 5,000 MMW (5000*BYR3600=US$10,000) and having number of staff as mentioned below; for industries - less than 200 people; in science and scientific services - less than 100 people, for construction and other productive sectors up to 50 people; for non-productive sectors up to 25 people.
vii Lump sum tax for stores that are single owned and total trading space less than 25 square meters, plus public catering enterprises, and at markets and sales exhibitions.
Bosnia & Herzegovina (Federation)
viii profit generated by foreign capital Bosnia & Herzegovina (Republic)
ix profit generated by foreign capital Bulgaria
x 20% profit tax for small businesses defined by taxable profit less than BGN 50,000 (US$22,200).
xi for sole traders.
Croatia
xii Newly established companies qualify for reduced tax rates and the reduction is higher for larger investments.
Czech Republic
xiii for inv. Over CZK 350 million (US$ 10 million) Georgia
xiv for enterprises with turnover less than GEL 24,000 (US$ 11,000) Hungary
xv SMEs can write off its tax by interest on loan used for investment in assets.
Kosovo
xvi 3% gross turnover tax for SMEs = turnover under 200,000 DEM (US$ 92,000) Kyrgystan
xvii SMEs(total revenue up to 3 million soms or approximately US$63 000) may pay from 5 to10% gross turnover tax instead of all national taxes above (apparently SMEs find this system unfavourable and rather use the general system). Individual entrepreneurs can optionally get a patent and pay a monthly gross turnover tax, i.e. in retail trade – 4%.
Latvia
xviii For inv. over US$ 16 million.
xix 20% profit tax for SMEs meeting at least two of the following three conditions: book value of tangible assets – 70 000 lats (EUR 123 700);net turnover – 200 000 lats (EUR 353 400);average number of employees – 25 persons.
Lithuania
xx 13% profit tax for small businesses with less than 11 employees and a gross annual income less than LTL 500,000 (US$ 130,000).
xxi Optional for firms with gross income less than 100,000 LTL (US$ 26,000) Macedonia (FYR)
xxii tax holiday for tax generated by foreign capital Moldova
xxiii SMEs may benefit from a 35% discount on profit tax for two years.
xxiv 50% tax discount given the first five years if foreign investments exceeds US$ 250,000
xxv Individual entrepreneurs can buy patent which involve a monthly fee.
Romania
xxvi for reinvested profit
xxvii for large FDI
xxviii micro enterprises with less than 10 employees and an annual turnover less than Euro 100,000.
Russia
xxix Planned from 2003; Small enterprises with annual turnover of 10 million roubles (US$320,000) and up to 20 employees will be entitled to choose between 8% turnover tax or 20% profit tax (standard 24%).
Slovak Republic
xxx 5 years tax holiday for FDI over EUR 5 million Turkmenistan
xxxi Tax breaks subject to negotiations. It is assumed that large firms have more negotiation power.
xxxii 20-24% profit tax, depending on nature of activity, for small legal entities defined by annual turnover less than TMM 72 million (US$ 14,000), or less than 50 persons in producing firms, or less than 10 persons in trading firms, or less than 25
persons in all other types of firms.
xxxiii Lump sum license for entrepreneur without a legal entity and with annual turnover less than 72 million manats (US$14,000).
Ukraine
xxxiv Firms with up to 50 employees and turnover less than UAH 1 million (US$ 190,000) can pay a 6% gross turnover tax which does not exempt actor from VAT, or 10% gross turnover tax which do exempt firms from VAT.
Uzbekistan
xxxv for FDI
xxxvi Optionally, small trading enterprises can pay 25% and small production enterprises can pay 10% tax of gross turnover instead of entire set of national taxes. Lump sum tax for individual entrepreneurs without a legal entity.
FRY Serbia
xxxvii tax discount amounting 30% of new investments for SMEs ( in comparison to 10% of new investments for non-SMEs).
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While steps to improve the investment climate are important, the hardening of budget constraints on all enterprises has also been key to the resumption and sustenance of growth in successful transition economies. The experience of the transition economies in the 1990s suggests that a sharp and early decline in aggregate employment preceded the rapid growth of new firms. This made assets cheaply available to new enterprises, which was useful when financing was not readily available and new investment was not forthcoming. When the proportion of employment in small firms reached a threshold of around 40 percent, the sector evolved from being a passive receptacle for absorbing resources into an active competitor, rapidly increasing its share of employment (see figure 12a). In countries where aggregate employment picked up, it did so after the recovery of aggregate output . When the threshold was not reached, people remained “unemployed on the job” as in the CIS and some countries in southeastern Europe. Aggregate employment started to fall only late in the process (see figure 12b). These observations suggest a sequence where hard budget constraints are imposed and the old sector declines before the new sector can grow. The complementarity between hardening budget constraints and improving the investment climate has been extremely important.
Our next question for the commentators is:
• Is it generally understood that hardening budget constraints for all firms and
improving the investment climate to create new firms and stimulate
entrepreneurship without the state dispensing special favors to old or new firms must go hand in hand?
Figure 12a. Index of GDP and Shares of Value Added and Employment Accounted for by Small Enterprises, 1989-98
Source: World Bank database on small and medium-size enterprises.
Lithuania
0 2 0 4 0 6 0 8 0 100 120
19891 9 9 01 9 9 119921 9 9 3199419951 9 9 619971998 0 1 0 2 0 3 0 4 0 5 0 6 0
GDP index Value added by small enterprises as percentage of total value added
Percentage of employees in small firms Percent
Index
Ukraine
0 20 40 60 80 100 120
1989 19901991 1992 1993 1994 19951996 1997 1998 0 10 20 30 40 50 60
Percent Index
Hungary
0 20 40 60 80 100 120
19891990 1991 1992 1993 19941995 19961997 1998 0 10 20 30 40 50 60 70
GDP index
Value added by small enterprises as percentage of total value added Percentage of employees in small firms Percent
Index Kazakhstan
0 20 40 60 80 100 120
1989 19901991 1992 1993 1994 19951996 1997 1998 0 10 20 30 40 50 60
Percent Index
Russian Federation
0 20 40 60 80 100 120
1989 1990 1991 1992 19931994 1995 1996 19971998 0 10 20 30 40 50 60
Index Percent
Czech Republic
0 20 40 60 80 100 120
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 0
10 20 30 40 50 60
GDP index
Value added by small enterprises as percentage of total value added
Percentage of employees in small firms
Index Percent
35
Table 12b. Employment and GDP, 1990-98
Source: World Bank database on small and medium-size enterprises.
Poland
40 60 80 100 120 140
1990 1991 1992 1993 1994 1995 1996 1997 1998
Employment GDP Hungary
40 50 60 70 80 90 100 110
1990 19911992 19931994 1995 1996 1997 1998
Employment GDP
Czech Republic
40 50 60 70 80 90 100 110
1990 1991 1992 1993 1994 1995 1996 1997 1998
Bulgaria
40 50 60 70 80 90 100 110
1990 199119921993 1994 1995 1996 1997 1998
Employment GDP
Kazakhstan
40 50 60 70 80 90 100 110
1990 1991 1992 1993 1994 1995 1996 1997 1998 Ukraine
30 40 50 60 70 80 90 100 110
1990 1991 1992 1993 1994 1995 1996 1997 1998
Romania
40 50 60 70 80 90 100 110
1990 1991 1992 1993 1994 1995 1996 1997 1998 Russian Federation
40 50 60 70 80 90 100 110
1990 199119921993 1994 1995 1996 1997 1998
Employment GDP
In light of this discussion, a major element of the agenda of tax reform is therefore
• to eliminate tax exemptions which reflect governance problems in tax administration rather than being equity-enhancing, as is the case, for example, in Georgia where it is estimated that an additional 2 percent of GDP could be collected from excise taxes on petroleum products and cigarettes19, and
• to devise a simplified tax regime for small businesses which relieves the administrative and reporting burden on the taxpayer and minimizes contact between the tax authorities and the taxpayer. The use of tax exemptions and tax relief for such firms is, however, not recommended, in part because potentially 50 percent or more of value added that is generated by small firms in successful transition economies would then escape the tax net, significantly worsening the go vernment’s fiscal position without targeting the particular failure, for example, insecurity of property rights or
inadequate infrastructure responsible for impeding the development of small firms.
This raises another question for the commentators:
• What is the appropriate tax treatment of small firms, which have been the key to growth and generation of employment? What political strategies are available
19 World Bank (2002b)
37
to eliminate tax exemptions that benefit powerful special interests and to lower tax rates and simplify tax administration that would benefit and encourage compliance by small firms?